After a protracted, nearly six-year legal battle, the $2.6 billion tax dispute between British telecommunications company Vodafone Group Plc. and the Indian government may soon be over. According to several recent media reports, the parties are close to a settlement.

Foreign investors have watched the case with great interest, using it as a gauge of the Indian government’s attitude toward their interests in the country, and they will use any settlement as a measure of how best to approach the country—or not approach it at all—going forward.
 
To some degree, the damage may already be done. According to Indian government statistics, foreign direct investment fell to $22.8 billion last year versus $34.6 billion in 2011. Though other factors have also played a role in that drop-off, lawyers say the government’s actions have definitely had an impact.
 
"There is this kind of doubt in people’s minds about how committed the government is to getting foreign investment and keeping it for the long term," says Cleary Gottlieb Steen & Hamilton senior India consultant Shreya Lal Damodaran, who is based in London.
 
The dispute stems from Vodafone’s $11 billion purchase of Indian mobile business Hutchison Essar Ltd. in 2007 from Hong Kong–based Hutchison Whampoa. The deal was structured using Vodafone’s Netherlands subsidiary and a Cayman Islands–incorporated subsidiary of Hutchison.
 
The Indian government has contended that Vodafone is obligated to pay more than $2 billion as a tax on the transaction, as the underlying asset in question—Hutchison Essar—is an Indian company. Vodafone has pushed back against that claim, saying that the transaction’s use of offshore entities makes it exempt from such a duty.
 
The two parties battled back and forth in court until January 2012, when India’s Supreme Court agreed with Vodafone that the offshore transaction was beyond the Indian government’s jurisdiction. But the Indian Parliament responded to that by passing a bill permitting it to tax such deals and to do so retroactively.
 
It’s that willingness to flout the judiciary and change long-established law to serve the government’s purposes that has raised significant concerns among foreign investors, according to Damodaran.
 
"That sends out a pretty stark message as to how things work in India," she says. As a result, the Vodafone case and its implications has been a regular topic of discussion with her clients. "It’s definitely on the table each time."
 
Jones Day London partner Sumesh Sawhney says the government was correct to try to collect taxes from Vodafone. "The country should not be denied its revenues," he says. "There are provisions around the world [in other countries] to capture this type of transaction."
 
But he agrees that the way the Indian government has acted has made foreign investors nervous. The attempt to tax these transactions retroactively, he says, "created a lot of uncertainty around the world in the minds of investors."
 
The tax dispute has been just one issue weighing on the minds of foreign investors over the past year.
 
Last year, India’s Supreme Court canceled 122 telecommunications licenses first issued to companies such as Norway’s Telenor ASA and Japan’s NTT DoCoMo Inc. in 2008, alleging corruption and saying that the government sold the licenses at below-market rates. The second-generation wireless spectrum in question is in the process of being auctioned off again by the Indian government.
 
Even India’s attempts to liberalize its economy—seen last September when the government announced its intention to open foreign investment in the retail and aviation sectors—have been slow to take hold, as populist opponents pushed back against the measures and potential investors struggled to decipher the new rules.
 
The very idea of foreign investment, much less ownership, remains controversial with many in India. For nearly five decades after independence from British rule in 1947, India pursued largely socialist economic policies in which foreign competition was explicitly kept out. It was only in the 1990s that the government began changing direction, and many policies remain held over from the earlier period.
 
In India, "when something opens up there are strings attached, and there are questions as to how those strings will be interpreted," says Baker & McKenzie Singapore partner Ashok Lalwani, who also serves as head of the firm’s Asia-based India practice.
 
Still, given the potential of the Indian market, foreign investors are likely to be patient. And many appear undeterred. Deals in the works include London-based Diageo Plc.’s proposed $2.1 billion purchase of a majority stake in India’s largest liquor company, United Spirits Ltd., and American generic drug maker Mylan Inc.’s $1.6 billion purchase of the injectable medicine unit of India’s Strides Arcolab Ltd.
 
But lawyers note that while clients have interest and have often moved to the stage of performing initial due diligence, only a handful of deals move forward. That has been the result of not only questions about India’s attitude toward foreign investment but also a host of other problems, including high inflation and a spate of corruption scandals. The still-struggling global economy hasn’t helped either.
 
"It hasn’t been bullish at all compared to previous years," says Cleary’s Damodaran. "People are still looking for opportunities, but they’re more hesitant to actually do the deal."
 
The current ruling coalition under Prime Minister Manmohan Singh is making some effort to smooth things over with the international business community. The government has agreed to postpone until 2016 implementation of some other tax regulations that foreign investors had complained were vague. Meanwhile, Finance Minister Palaniappan Chidambaram has been on a global public relations campaign stressing that India is very much open for business.
 
On the other hand, the country is headed toward a national election in 2014, and politicians will be tempted to play the populist card on the issue of opening India’s markets. The main opposition Bharatiya Janata Party has staked out a position against the liberalization of the nation’s retail sector, though some observers have noted that the BJP was friendlier to foreign investment the last time it was in power.
 
Lawyers say that clients will likely maintain a wait-and-see attitude in response. Jones Day London partner Sumesh Sawhney says he expects neither a significant uptick nor downturn in foreign investment this year, but rather a steady pace of deals until next year’s elections.
 
"[The election] will decide to a very large extent how India goes forward over the next five years," he says.
 
But he thinks the country’s relatively high growth rates will mean foreign businesses aren’t close to giving up on India, despite the political and economic volatility.
 
"Companies are saying, ‘We have to be in India,’ which even in the worst of times is growing at 5 percent," says Sawhney.
 
Email: tbrennan@alm.com .